Fiscal adjustments
by
Steinar Holden
Department of Economics
University of Oslo
Box 1095 Blindern
0317 Oslo
Email: steinar.holden@econ.uio.no
Homepage: http://folk.uio.no/~sholden/
First version: 27 January 2005
NB: Preliminary version
Errors may occur
Abstract
Recent literature has argued that to reduce public debt
permanently, a government has to cut public expenditure,
specifically government employment and transfers. Tax
increases supposedly give only a temporary reduction in
public debt. This paper explores this conclusion using a new
fiscal indicator, building on the indicator proposed by
Braconier and Holden (1999).
JEL Codes: E6, H6
Keywords: fiscal policy, fiscal indicators, budget indicators
1
Alesina and Perotti (1995) (AP) argue that
• to reduce public debt permanently, a government has to
cut public expenditure, specifically government
employment and transfers, while tax increases don’t work
“Permanent improvements are implemented mainly via cuts in
two types of expenditure: transfer programmes and
compensation of government employees. Temporary
improvements are carried out almost exclusively via tax
increases”
This finding has received considerable attention in the
literature, and also in textbooks, e.g. David Romer Advanced
Macroeconomics, (2001), page 547.
Ardagna, EER 2004, find smaller difference between tax
increases and expenditures, but with a different method from
AP, and without comparing explicitly.
Is AP’s conclusion valid?
2
Alesina and Perottis’s analysis
19 OECD countries over the period 1960 - 92
Definition 1
Fiscal adjustment:
Strong fiscal adjustment is a year with very tight fiscal stance,
defined as a discretionary change in budget balance greater
than 1.5 percent of GDP
Discretionary change in budget balance is defined by use of
Blanchard’s fiscal impulse; what the budget balance would
have been if unemployment had remained the same as in the
previous year.
I.e. adjust the primary deficit (i.e. without net interest
payments) for the effect of the change in unemployment.
Similar results when using OECD structural budget balance
instead of Blanchard’s fiscal impulse.
3
Definition 2
Successful adjustment:
A successful adjustment in year t is defined as a very tight
fiscal stance in year t such that the gross debt/GDP ratio in
year t+3 is at least 5 percentage point of GDP lower than in
year t.
Focus on gross debt because
• common in literature
• Maastricht criteria
• does not depend on valuation of government financial assets
• but problem due to effect of sales of gov’t financial assets.
4
Table 11, AP
Successful
adjustment (14 obs)
-2.74
(0.282)
-2.19
(0.326)
0.44
(0.385)
Unsuccessful
adjustment (38 obs)
-2.18
(0.101)
-0.49
(0.188)
1.28
(0.181)
Successful
adjustment (14 obs)
Expenditure
-2.193
(0.326)
Public investment -0.41
(0.089)
Transfers
-0.54
(0.183)
Non-wage public
-0.38
consumption
(0.055)
Government wages -0.58
(0.093)
Subsidies
-029
(0.211)
Unsuccessful
adjustment (38 obs)
-0.49
(0.188)
-0.26
(0.046)
-0.02
(0.102)
-0.09
(0.038)
-0.07
(0.071)
-0.08
(0.047)
Fiscal impulse
Expenditure
Revenues
Table 12, AP
5
This paper:
Explore whether AP’s conclusion is valid,
• using a novel fiscal indicator
• a more sophisticated analysis
(Frankly, another motivation for the study is to apply the novel
indicator)
The new fiscal indicator
Decomposition of the change in the budget balance into
• Discretionary changes are the effect of changes in the
fiscal policy.
• Induced changes arise as a consequence of changes in the
economy; these are the changes that would take place even
if fiscal policy were constant.
In contrast, the OECD Structural budget balance distinguishes
between
• structural changes
• cyclical changes
6
Revenues: unchanged fiscal policy implies that tax
revenues are proportional to their respective tax bases.
Distinguish between five different tax types.
• Direct taxes on households (TD) are proportional to pre-tax
household income (Hinc).
• Direct taxes on the business sector (TB) are proportional to
business income (Binc).
• Social security contributions (TS) are proportional to the
wage bill, excluding soc sec contributions (WL)
• Indirect taxes (TI) are proportional to private consump.
• Other revenues (TO) are proportional to GDP (Y).
(1) ∆TIt ≡ TD,t-1 (Hinct/Hinct-1 –1)+ TB,t-1 (Binct/Binct-1 –1)+ T
S,t-1(WLt/WLt-1
–1)
+ TI,t-1(Ct/Ct-1 –1) + TO,t-1(Yt/Yt-1-1)
The discretionary change in revenues is defined as a residual
(2) ∆TDt ≡ ∆Tt - ∆TIt,
I.e. there is a discretionary increase in taxes if tax revenues
increase above the growth in the tax bases.
7
For expenditures, excluding interest spending and capital
transfers and other capital payments, unchanged policy is
defined as
• Public expenditures (excl. unemployment benefits) are
proportional to trend GDP.
∆GIO,t ≡ GO,t-1 ( YTt /YTt-1 – 1)
• Unemployment benefits, as a share of trend GDP, are
proportional to the rate of unemployment.
∆GIU,t ≡ GU,t-1 [(Ut /Ut-1)( YTt /YTt-1) – 1]
(trend real growth = average of real growth in past 10 years)
Total induced change in government expenditure is
(4) ∆GIt ≡ ∆GIO,t + ∆GIU,t
Total discretionary change is a residual
(5) ∆GDt ≡ ∆Gt – ∆GIt
8
The discretionary change in the budget balance (lower case
denotes ratio to GDP)
(6) ∆bDt ≡ ∆tDt - ∆gDt
The overall budget balance is
(7)
Bt = Tt – Gt - iDt
iDt is net interest payments
The induced change in the budget balance, as a ratio to GDP,
is defined as a residual
(8)
∆bIt ≡ (B/Y)t - (B/Y)t-1 – ∆bDt.
(implying that net interest payments are treated as induced)
In contrast, the OECD structural budget balance adjusts the
primary deficit for the effect of the output gap, i.e. the
difference between actual and potential output. This implies
that transfers and tax revenues are adjusted for changes in
GDP.
9
Illustration of the motivation for the fiscal indicator:
The crisis in Finland and indicators of fiscal stance
Dramatic economic downturn in the early 1990s due to
disruption of considerable exports to former Sovjet Union, as
well as debt problems and banking crisis.
Sharp reduction in GDP in 1991-92, while the fall in the main
tax bases was lagging behind.
The OECD indicator, the Structural Change Index (SCI)
(which is the change in the Structural budget balance)
“overadjusted” the budget balance for the reduction in GDP,
and misleadingly indicated a neutral fiscal stance in 1992-94.
In contrast, when the growth in the tax bases were lagging
behind GDP-growth, 1993-95, the OECD indicator did not
show a tight fiscal stance in 1995-97
10
GDP growth
Tax base growth
Unemployment
FINLAND
0.2
0.15
0.1
0.05
0
-0.05
-0.1
1981
1983 1985
1987 1989
1991 1993
1995
1997 1999
2001
FINLAND
0.04
0.03
0.02
0.01
0
dbd
sci
-0.01
-0.02
-0.03
-0.04
-0.05
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
-0.06
11
Returning to the comparison with AP:
Evolution of debt as a ratio to GDP:
Standard notation, D is debt, the total budget deficit is -B =
∆D = G – T + iD-1 (debt measured at the end of the year)
⎛D⎞ ⎛D⎞
∆⎜ ⎟ = ⎜ ⎟
⎝ Y ⎠t ⎝ Y ⎠t
=
D − Dt −1 Dt −1 Dt −1
⎛D⎞
−⎜ ⎟ = t
+
−
Y
Y
Y
Yt −1
⎝ ⎠t −1
t
t
∆Dt Dt −1 Yt −1 Dt −1 ∆Dt ⎛ Yt −1 ⎞ ⎛ D ⎞
∆Dt ∆Yt ⎛ D ⎞
+
−
=
+⎜
− 1⎟ ⎜ ⎟ =
−
⎜ ⎟
Yt
Yt −1 Yt
Yt −1
Yt
Y
Y
Y
Yt ⎝ Y ⎠t −1
t
⎝ t
⎠ ⎝ ⎠t −1
using ∆Dt/Yt = -Bt/Yt = ∆bIt + ∆bDt + (B/Y)t-1,
(9) ∆(D/Y)t = ∆bIt + ∆bDt. - (B/Y)t-1 – (∆Y/Y)t (D/Y)t-1 ,
AP make a point that cyclical changes in the budget deficit are
removed (corresponding to ∆bIt ), but they do not discuss the
latter two components
• lagged deficit (B/Y)t-1 and
• growth-induced reduction in debt (∆Y/Y)t (D/Y)t-1 ,
12
Our analysis: 18 OECD countries, 1970-2002, Gross debt
Successful
adjustment (20 obs)
Fiscal impulse
0.025
(dbd)
(.008)
Expenditures (dgd) -0.009
(0.007)
Revenues (dtd)
0.016
(0.010)
-0.014
Lagged deficit
(0.026)
(B/Y)t-1
Growth-induc. red. 0.154
(0.063)
(∆3Y/Y)t(D/Y)t-1
Lagged debt
0.640
(D/Y)t-1
(0.252)
Unsuccessful
adjustment (79 obs)
0.026
(0.015)
-0.007
(0.010)
0.019
(0.012)
-0.044
(0.049)
0.142
(0.098)
0.619
(0.308)
We observe:
• almost no difference in change in expenditures
• almost no difference in change in revenues
• large difference in lagged deficit (over a three year period, 3
percent higher deficit will lead to about 9 percent higher
debt ratio)
• no difference in initial debt nor in “growth-induced”
reduction in debt
Success of adjustment depends on the initial level of deficit
Similar picture with net public debt; where lagged deficit
differs by 5 percent (-0.001 and -0.051)
13
| country year fiscadj successg |
|-----------------------------------------|
1. | Canada 1996
5
1|
2. | Canada 1997
5
1|
3. | Denmark 1986
5
1|
4. | Denmark 1999
5
1|
5. | Denmark 1985
5
1|
|-----------------------------------------|
6. | Finland 1998
5
1|
7. | Finland 2000
5
1|
8. |
Italy 1997
5
1|
9. | Netherlands 1972
5
1|
10. | Netherlands 1973
5
1|
|-----------------------------------------|
11. | New Zealand 1993
5
1|
12. | New Zealand 2001
5
1|
13. | Norway 1996
5
1|
14. | Norway 1980
5
1|
15. | Norway 1995
5
1|
|-----------------------------------------|
16. | Norway 1994
5
1|
17. | Sweden 1997
5
1|
18. | Sweden 1987
5
1|
19. |
UK 1980
5
1|
20. |
UK 1998
5
1|
14
Extended analysis, using all observations, not only the
observations with very tight fiscal policy.
First, considerable data problems in the sense that the budget
identity does not hold.
∆(D/Y)t = - (B/Y)t - (∆Y/Y)t (D/Y)t-1
Regressing ∆(D/Y)t on (B/Y)t + (∆Y/Y)t (D/Y)t-1,
we obtain (using gross debt)
∆(D/Y)t = 0.73 {(B/Y)t +(∆Y/Y)t (D/Y)t-1 },
R2 = 0.46
With net debt, we obtain
∆(D/Y)t = 0.95 {(B/Y)t +(∆Y/Y)t (D/Y)t-1 },
R2 = 0.51
Thus, the statistical discrepancy due to valuation-changes of
financial assets, sales of financial assets, one-off events, etc, is
considerable.
15
Panel data estimation:
Dependent variable: The change in the gross debt ratio
∆3(D/Y)t+2 = (D/Y)t+2 - (D/Y)t-1
N = 443
Coef.
Std. Err Coef.
dgd
3.13
0.33
dgi
6.19
0.38
dtd
-2.41
0.27
dti
-3.46
0.43
(B/Y)t-1
-1.53
(∆3Y/Y)t(D/Y)t-1
Std. Err
2.01
0.45
-0.65
0.33
0.10
-1.08
0.12
-0.70
0.05
-0.21
0.05
_cons
0.01
0.01
0.03
0.01
_ R2
0.56
0.16
Some indication that discretionary change in expenditure has
greater impact on the change in the debt ratio than the
discretionary change in taxes has.
16
Dependent variable: The change in the net debt ratio
∆3(D/Y)t+2 = (D/Y)t+2 - (D/Y)t-1
N = 443
Coef.
Std. Err Coef.
dgd
3.71
0.35
dgi
6.05
0.39
dtd
-3.39
0.28
dti
-4.86
0.40
(B/Y)t-1
-2.08
(∆3Y/Y)t(D/Y)t-1
Std. Err
2.59
0.42
-1.42
0.32
0.11
-2.09
0.14
-0.56
0.04
-0.55
0.05
_cons
0.03
0.01
0.01
0.01
_ R2
0.59
0.35
What can explain the difference in effect of changes in
expenditure and taxes?
• Persistence in adjustment
• Effect on GDP growth
• Spurious correlation
17
Dependent variable: dgd
Source |
SS
df
MS
Number of obs = 450
-------------+--------------------------F( 6, 443) = 11.53
Model | .00667 6
.00111
Prob > F = 0.0000
Residual | .04275 443 .000096
R-squared = 0.1351
-------------+------------------------------Adj R-squared = 0.1233
Total | .04942 449 .00011
Root MSE
= .00982
-------------------------------------------------------------------------dgd
| Coef. Std. Err. t –value
----------------------------------------------------dgd
|
L1 | .2481324 .0456562 5.43
L2 | -.0748581 .0452475 -1.65
dtd
|
L1 | -.0524612 .0333692 -1.57
(B/Y)
|
L1 | .0746334 .015686 4.76
(D/Y)
|
L1 | .0025336 .0018419 1.38
3 T
(∆ Y /YT)| .0060944 .0029005 2.10
_cons
| -.0001249 .0010112 -0.12
-------------------------------------------------------------------L1 denotes one lag
Evidence that discretionary adjustment of expenditure is
persistent
18
Dependent variable: dtd
Source |
SS
df
MS
Number of obs = 465
-------------+------------------------------ F( 6, 458) = 8.50
Model | .0088 6 .001
Prob > F = 0.0000
Residual | .0797 458 .00017
R-squared = 0.1002
-------------+--------------------Adj R-squared = 0.0884
Total | .0886 464 .0001
Root MSE
= .0132
-------------------------------------------------------------------------dtd
|
Coef. Std. Err. t-value
----------------------------------------------dgd
|
L1 | -.0168938 .0597263 -0.28
dtd
|
L1 | .1348477 .0447304 3.01
L2 | -.080253 .0438723 -1.83
(B/Y)
|
L1 | -.1033305 .0205852 -5.02
(D/Y)
|
L1 | -.0059312 .0023771 -2.50
3 T
(∆ Y /YT) | .0083852 .0039142 2.14
_cons
| -.0002403 .001329 -0.18
--------------------------------------------------------------------------L1 denotes one lag
Evidence that discretionary adjustment of taxes is persistent,
but less so than expenditure.
19
Dependent variable: dgdp (GDP – growth)
Source |
SS
df
MS
Number of obs = 559
-------------+---------------------F( 5, 553) = 282.17
Model | .98141 5
.19
Prob > F = 0.0000
Residual | .3846 553 .000695 R-squared = 0.7184
-------------+------------------------Adj R-squared = 0.7159
Total | 1.366 558 .00244
Root MSE = .02637
--------------------------------------------------------------dgdp
|
Coef. Std. Err.
t -values
-------------+-------------------------------------------------------dtd
|
L1 | -.0822291 .0837724 -0.98
dgd
|
L1 | .3545363 .1124326 3.15
dgdp
|
L1 | .4112334 .0495375 8.30
L2 | -.2957682 .0491912 -6.01
3 T
(∆ Y /YT) | .1883783 .0164863 11.43
_cons
| .0172468 .0023748 7.26
-------------------------------------------------------------------------Does expenditure have a positive impact on GDP- growth,
which would reduce the effect on debt ?
20
Dependent variable: dgdp (GDP – growth)
Source |
SS
df
MS Number of obs = 528
-------------+----------------------F( 9, 518) = 159.60
Model | .9514 9 .1057
Prob > F = 0.0000
Residual | .3430 518 .00066 R-squared = 0.7350
-------------+-----------------------------Adj R-squared = 0.7304
Total | 1.29452 527 .002
Root MSE = .02574
----------------------------------------------------------------------dgdp
|
Coef. Std. Err. t-value
-------------+-------------------------------------------------------dtd
|
-- | .2569406 .0850816 3.02
L1 | -.1365593 .0841232 -1.62
L2 | -.068974 .0844821 -0.82
dgd
|
-- | -.5445395 .1177279 -4.63
L1 | .5213867 .1214715 4.29
L2 | -.1277002 .1154573 -1.11
dgdp
|
L1 | .4613033 .0508272 9.08
L2 | -.2323622 .0521239 -4.46
3 T
(∆ Y /YT) | .1623048 .0170007 9.55
_cons
| .0150339 .0024467 6.14
Significant coefficients, but no clear effect of discretionary
expenditure on GDP -growth
21
Dependent variable: (∆3Y/Y)t+2
(GDP –growth over 3 years)
Source |
SS
df
MS
Number of obs = 547
-------------+---------------------F( 4, 542) = 248.01
Model | 9.6551 4
2.413
Prob > F = 0.0000
Residual | 5.275 542 .0097
R-squared = 0.6467
-------------+-----------------------Adj R-squared = 0.6441
Total | 14.9302 546 .0273
Root MSE = .09865
-------------------------------------------------------------------------F2.d3gdp | Coef. Std. Err.
t - values
-------------+-----------------------------------------------------------dgd
| .1164163 .4213446 0.28
dtd
| .3349165 .3141267 1.07
(B/Y)
|
L1 | .0739653 .111165 0.67
3 T
(∆ Y /YT) | .7083434 .0234001 30.27
_cons
| .0589786 .0085737 6.88
No evidence of impact on GPD-growth over the next three
years.
22
Conclusions:
• The success of fiscal adjustments depends on the level of
deficit, not whether the adjustment is undertaken by
increasing taxes or reducing expenditure.
• Nevertheless some evidence that discretionary reduction in
public expenditure has a greater impact on the evolution of
public debt than discretionary tax increases have.
• Some evidence that discretionary reduction of public
expenditure is more persistent than discretionary increases
in tax.
• No evidence that discretionary changes in expenditure or
taxes affect the average GDP-growth over the next three
years.
23
. +-----------------------------------------+
| country year fiscadj successg |
|-----------------------------------------|
1. |
Canada 1996
5
1|
2. |
Canada 1997
5
1|
3. | Denmark 1986
5
1|
4. | Denmark 1999
5
1|
5. | Denmark 1985
5
1|
|-----------------------------------------|
6. | Finland 1998
5
1|
7. | Finland 2000
5
1|
8. |
Italy 1997
5
1|
9. | Netherlands 1972
5
1|
10. | Netherlands 1973
5
1|
|-----------------------------------------|
11. | New Zealand 1993
5
1|
12. | New Zealand 2001
5
1|
13. |
Norway 1996
5
1|
14. |
Norway 1980
5
1|
15. |
Norway 1995
5
1|
|-----------------------------------------|
16. |
Norway 1994
5
1|
17. |
Sweden 1997
5
1|
18. |
Sweden 1987
5
1|
19. |
UK 1980
5
1|
20. |
UK 1998
5
1|
|-----------------------------------------|
21. | Austria 1996
5
2|
22. | Austria 1997
5
2|
23. | Austria 1981
5
2|
24. | Austria 2001
5
2|
25. | Austria 1984
5
2|
|-----------------------------------------|
26. | Belgium 1982
5
2|
27. | Belgium 1993
5
2|
28. | Belgium 1984
5
2|
29. | Belgium 1985
5
2|
30. | Belgium 1987
5
2|
|-----------------------------------------|
31. | Belgium 1983
5
2|
32. | Belgium 1977
5
2|
33. |
Canada 1986
5
2|
34. |
Canada 1987
5
2|
35. |
Canada 1995
5
2|
|-----------------------------------------|
36. |
Canada 1981
5
2|
37. |
Canada 1994
5
2|
38. | Denmark 1981
.
2|
24
39. | Denmark 1984
5
2|
40. | Denmark 1983
5
2|
|-----------------------------------------|
41. | Finland 1984
5
2|
42. | Finland 1993
5
2|
43. | Finland 1976
5
2|
44. | Finland 1994
5
2|
45. | Finland 1988
5
2|
|-----------------------------------------|
46. | Finland 1981
5
2|
47. |
France 1994
5
2|
48. |
France 1987
5
2|
49. |
France 1996
5
2|
50. |
France 1979
5
2|
|-----------------------------------------|
51. |
France 1984
5
2|
52. |
France 1983
5
2|
53. | Germany 1976
5
2|
54. | Germany 1994
5
2|
55. | Germany 1993
5
2|
|-----------------------------------------|
56. | Germany 1996
5
2|
57. | Germany 1969
5
2|
58. | Germany 1982
5
2|
59. | Germany 1983
5
2|
60. | Germany 1966
5
2|
|-----------------------------------------|
61. | Germany 1973
5
2|
62. | Germany 1997
5
2|
63. |
Italy 1980
5
2|
64. |
Italy 1982
5
2|
65. |
Italy 1995
5
2|
|-----------------------------------------|
66. |
Italy 1967
5
2|
67. |
Italy 1986
5
2|
68. |
Italy 1976
5
2|
69. |
Italy 1993
5
2|
70. |
Italy 1990
5
2|
|-----------------------------------------|
71. |
Italy 1983
5
2|
72. |
Japan 1990
5
2|
73. |
Japan 1974
5
2|
74. |
Japan 1984
5
2|
75. |
Japan 1981
5
2|
|-----------------------------------------|
76. | Netherlands 1982
5
2|
77. | Netherlands 1981
5
2|
78. | Netherlands 1983
5
2|
79. | Netherlands 1993
5
2|
80. | Netherlands 1991
5
2|
25
|-----------------------------------------|
81. |
Norway 1999
5
2|
82. |
Norway 1983
5
2|
83. |
Norway 2000
5
2|
84. |
Norway 1985
5
2|
85. |
Spain 1996
5
2|
|-----------------------------------------|
86. |
Spain 1992
5
2|
87. |
Spain 1994
5
2|
88. |
Sweden 1995
5
2|
89. |
Sweden 1971
5
2|
90. |
Sweden 1994
5
2|
|-----------------------------------------|
91. |
Sweden 1996
5
2|
92. |
Sweden 1976
5
2|
93. |
Sweden 1984
5
2|
94. |
Sweden 1975
5
2|
95. |
Sweden 1989
5
2|
|-----------------------------------------|
96. |
Sweden 1983
5
2|
97. |
UK 1997
5
2|
98. |
UK 1981
5
2|
99. |
UK 1977
5
2|
100. |
US 1969
5
2|
+-----------------------------------------+
26
Blanchard’s fiscal impulse
Estimate (TREND1 for 1960-75, TREND2 for 1976-92)
(1) TRANSFt = α 0 + α1TREND1 + α 2TREND 2 + α 3U t + ε t
Then calculate
)
)
)
(2) TRANSFt (U t −1 ) = α 0 + αˆ1TREND1 + αˆ 2TREND 2 + α 3U t −1 + ε t
Total primary expenditures, gt, equals tranfer expenditures
TRANSF and non-transfer expenditures gNT,t;
gt(Ut) = TRANSFt(Ut) + GNT,t.
Consequently, non-transfer expenditures are assumed to be
unaffected by the unemployment rate under a constant fiscal
policy. By applying the same procedure to total revenues, tt, to
obtain tt(Ut-1), we can construct the fiscal impulse as the
difference between the unemployment-adjusted deficit and
previous year’s deficit:
(3)
BFI t = ( g t (U t −1 ) − t t (U t −1 )) − ( g t −1 − t t −1 ) ,
27